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Next Stop For The 10Y Treasury: 0.25%

Courtesy of ZeroHedge View original post here.

Authored by Ian Lyngen, Ben Jeffery and Jon Hill, rates strategists at BMO Capital Markets

A glance at the calendar for today reveals effectively no new information to provide trading direction in the Treasury market; it’s always the quiet ones. As has been the case thus far in the week, the primary impetus is far more likely to come from other asset classes as the meltdown in the energy sector has weighed on global equities and triggered more systemic concerns. The early bounce in the crude oil market offers a degree of solace and supports the narrative that the May 20 contract’s plunge into negative territory was an isolated event. Surely, judgment will be reserved until the June 20 contract is in a comparable proximity to expiry in a month. For the time being however, extracting a sense of calm and stability from the overseas session for oil has allowed yields and global equities to drift higher.

We’d be remiss to assume today will offer any paradigm-shifting developments; after all, the global economy is in the midst of a pandemic, central banks are pumping in unprecedented amounts of liquidity, and fresh rounds of fiscal stimulus are being prepared. With this backdrop, there is little risk to the repricing which has landed 10-year yields in a definable range for the last month. Tuesday’s price action expanded the lower bound by 2 bp to 54 bp (matching the closing level from March 9 when rates set the record low). Highlighting a two basis point change in the near-term trading parameters speaks to just how range-bound the Treasury market has become since mid-March. In considering what would be required to break this range, an important lesson from Monday was that negative oil prices won’t be sufficient.

The Fed’s elevated participation in the secondary market for US debt – effectively monetizing the deficit – has recast investors’ expectations in terms of realizable volatility. Limitless QE has been instrumental in this transition, as has the conversation championed by Fed officials regarding the potential for yield curve caps.

What then needs to change to put 1.0% or 0.25% 10s on the table? First, we see the latter as more realistic than the former in the near-term. This is predicated the assumption that while it is widely consensus that ‘things are going to get worse’ in terms of the pandemic’s impact on real output, the downward pressure on inflation is gaining traction and yet to be fully incorporated in financial markets. The implications for the curve are relatively straightforward with the front-end anchored to Fed expectations; any concerns about the ability to create demand-side inflation given the excess liquidity in the system will translate to a flatter curve.

Our baseline assumption has been that the combined monetary and fiscal stimulus would eventually create an inflationary impulse once the domestic economy reopens. The first leg down in energy prices during March complicated this outlook – this week’s collapse of oil will have a greater impact if it proves to be sustainable. Headline CPI will struggle on fuel costs alone and the damage to the labor market points to zero (or negative) wage pressure as 2020 unfolds. This will make the demand-driven organic inflation the Fed has been seeking extremely elusive in the coming months. This isn’t to say reflation is off the table; simply delayed until later in the year or 2021. 

Recall that the Fed was already struggling with inflation creation long before Covid-19 redefined the global economy. If an environment with nearly full employment is unable to trigger the needed wage-gains, then how does the layoffs of millions of workers augment the problem. In a vacuum, it would simply exaggerate the issue, but Powell’s swift and aggressive move into an extremely accommodative monetary policy stance will eventually assist in the process. Our biggest concern is a repeat of the period following the last financial crisis in which asset price inflation was all that global monetary policy was ultimately able to achieve and the experience of 2020 has demonstrated the underlying fragility of those gains.


 


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